Analyzing KHCB's Financials -- The Weakest Link: Profit Rate Risk

Paging Anne Robinson

Continuing our analysis of KHCB to examine its potential to support GFHFG's new strategy ..

Quick Summary (for the Twitter Generation): Profit Rate Risk (AKA Interest Rate Risk) appears very high at KHCB.  Thus, a poor "fit" with GFH's new strategy.

Let's start by taking a look at yield on KHCB's loan portfolio yield to set the stage.

Portfolio Yield

Sometimes banks don’t book “air” for AIR (Accrued Interest or "Income" Receivable).  Or if they realize or are forced to realize they have, they reverse it out.  When they do this, they generally don’t provide details.  But, if the amounts are large enough, the gross yield on the lending portfolio will decrease significantly.  Lower rates on renegotiated loans and non-accrual on income in part or full on some loans can also depress gross yield.  Trends in portfolio yield can also reveal if a bank is taking more risk relative to its peers.   

Gross yield—which is the amount of interest owed by borrowers—is best because trends are not masked by changes in cost of funding (COF) as they are with net yield.   However, one does need to keep an eye on COF.

Why?

Because bank loans are generally priced over defined COF typically against bank benchmarks, e.g., LIBOR, as a proxy for the lending bank’s cost of funds.   Note actual funding of loans is independent of their price setting mechanism.  There is nothing to prevent a bank from pricing a loan over three month Libor and using overnight funding or more than three month funding.  That mismatch is how a bank’s Treasury earns its keep.

If we’re using gross yield (margin + contractual cost of funds) to identify whether changes are due to credit problems or other causes, then we need to be able to isolate the impact of COF to determine if COF is driving changes in gross yield through the loan pricing mechanism.  

The first step is determining COF on bank placements (deposits). If financials provide a breakdown of COF for bank placements separate from customer placements, the analyst’s job is easier. When they do not, analysis is a bit more difficult as the reported COF includes both bank and non-bank deposits.  KHCB only provides a total COF which includes both bank and client placements. In KHCB’s case, analysis is complicated further because the relative percentages of bank and client deposits changed over the period analyzed.

The second step is determining the contractual pricing basis of assets.  This is usually in the “risk management note” near the end of the financial statement.  The “Islamic” equivalent of a conventional bank’s “interest rate risk” is “profit rate risk.”  That is, is the bank making loans that reprice every three months?  Every 12 months?   Every 240 months?

Some technical notes for the charts below:

1.   Portfolio yield is on “Financing Assets” and “Assets for Leasing” because gross revenue is given as a single figure for both.  Again not ideal from the analyst’s perspective. 

2.   COF is based on bank placements and placements from clients (non-bank institutions and individuals) because there was no breakdown of the components. 

3.   Current accounts are excluded because they are not relevant to loan pricing as explained above. 

4.   Percentages are calculated using a simple average (beginning of period and end of period) for both the loan portfolio and the “deposits”. 

5.   Contractual repricing data is as of FYE (31 December) for the years shown as per respective ARs. For 2015 see AR 2015 Note 34 page 75.

KHCB Lending Yield and COF Analysis
	3Q16	2Q16	1Q16	FY15	FY14	FY13	FY12
FA & LA	5.80%	6.34%	6.30%	5.91%	6.84%	6.63%	7.57%
Depo COF	2.37%	2.26%	2.18%	2.51%	2.81%	3.24%	2.65%

Contractual Repricing of FA & LA Portfolios -- KHCB and BIsB
KHCB
Months	Up to 3	3 to 6	6 to 12	12 to 36	Over 36
2015	12%	4%	9%	20%	54%
2014	16%	7%	6%	20%	52%
BIsB
Months	Up to 3	3 to 6	6 to 12	12 to 36	Over 36
2015	6%	2%	5%	15%	72%
2014	14%	1%	6%	14%	64%

Contractual Repricing of FA & LA Portfolios – QIB
Months	Up to 3	3 to 12	12 to 60	60+
2015	41%	28%	22%	9%
2014	47%	27%	24%	3%

Comments on Portfolio Yield

1.   As the second chart above shows, KHCB and BIsB are largely fixed rate lenders.  So it’s no surprise that portfolio yield is not correlated with COF.

2.   Qatar Islamic Bank was “summoned” to this discussion to show what appears to be a more commercial bank lending portfolio. That is, heavily weighted to one year and under.  QIB owns to an effective profit rate of 4.2% (2015) and 4.32% (2014).  Not bad.  A natural question is what risks KHCB is running for an extra 1.6% and whether the risk/reward tradeoff is prudent. 

3.   Given this, KHCB and BIsB’s yield changes are driven by credit “events” on existing loans and leases (nonaccrual, reversal of AIR) and to a lesser extent by changes in market pricing for new loans and leases.  Because both banks are making long dated loans, the portfolio turns over slowly.  New financings are relatively small compared to the existing “book”. Thus, new financings only marginally affect gross yield.  If the portfolio “suddenly” increased or decreased (write-offs for example) by a large amount, this could affect net portfolio yield if current market rates were substantially different than those on the existing portfolio.  

4.   From FYE 2015 to 3Q16, KHCB’s FA & LA portfolio increased BHD 64 million point to point. Looking at simple average outstandings by quarter in 2016, the increase in 3Q16 was roughly BHD 26 million.  As the below table shows that new business would have to have been booked at less than a zero yield to cause a 50 bp drop in overall portfolio yield. That seems unlikely. 

5.   Thus, the drop in yield in 3Q16 is almost certainly credit related, e.g., non-accrual perhaps accompanied by reversal of previous period accruals, renegotiation of loans as a lower rate, or a combination of these factors. 

6.   If KHCB had maintained the 6.30% yield of 1Q16 and 2Q16 in 3Q16, gross interest revenue would have been roughly BHD0.560 million higher.   

7.   It doesn’t seem likely that the 3Q16 BHD2.2 million specific provision is solely responsible for the drop as nine months’ interest would be roughly BDH0.100 million using an average 6.3% portfolio yield.    

8.   So what would it take? 

9.   Assuming the yield should be 6.3%, the table below summarizes the single period amounts and rates at which they would have to be accrued (0% to 5%) to reduce the overall portfolio yield to 5.80%.  Note this analysis is for the full 50 bps drop.  Thus, it’s an analytical shortcut, ignoring Q1 and Q2 potential reversals on the 3Q BHD 2.2 provision and perhaps further back into 2015 if there was related AIR.  While a shortcut, it’s close enough for directional analysis.  Also note the required change is calculated using a simple average portfolio outstandings, e.g., (2Q+3Q)/2.   

10. In guesstimating probabilities of the above scenarios, AA thinks that zero accrual scenario is more likely that a massive renegotiation of loans to 5%.  Or partial accruals at the intermediate rates.   

5.80% Portfolio Yield "Required" Accrual Scenarios
Accrual Rate	0%	1%	2%	3%	4%	5%
BHD Millions	32	38	46	60	87	153
% FA & LA	7%	8%	10%	14%	19%	34%

 Comments on Profit Rate Risk    

1.   Profit Rate Risk (PRR) is the “Islamic” equivalent of conventional bank Interest Rate Risk a measure of the exposure of a bank to movements in interest rates.  If assets and liabilities are matched in terms of currency, actually repriced according to contractual repricing, and maturities then the bank has no interest or profit rate risk. It has locked in its net interest margin for the life of the loan absent credit events. 

2.   Banks generally don’t match 100% because they can make additional revenue through mismatching, typically borrowing short and lending long, assuming a “normal” upward sloping yield curve. 

3.   Another key factor and one which AA suspects is at play here is that typically sources of matching long dated funding are limited or non-existent.  Banks might want to match fund but they can’t.  Banks have three choices.  Make the fixed rate loan and short fund.  Refrain from making fixed rate loans for these tenors. Or make floating rate loans that reprice frequently.   An example would be a ten year loan that is priced off six-month Libor. 

PRR (IRR) comes in two flavors:  income risk and asset risk.  

1.   Income Risk:  If a bank matches as described above, and locks in its margin, changes in interest rates (COF) do not affect its income.  If it does not, it runs the risk that funding costs will exceed the earnings on the asset.  Think of First Penn or UBAF Arab American (NYC).  Both purchased long dated “riskless” US Treasury securities but funded with short dated money in the repo market.  As rates rose, first profit evaporated and then earnings went negative.  Both foundered. 

2.   Asset Price Risk:  With a fixed rate instrument, if market rates go up, the value of the instrument goes down.  Duration and convexity are measures of this risk--most familiar to bond investors.  Because loans and leases are in KHCB’s “banking book”, they are carried at historic cost less impairment for credit reasons.  IFRS doesn’t require that banking book assets be fair valued with losses or gains through income or directly in equity.   

3.   Risk Management:  In discussing management of market risks in its 2015 AR (page 73), KHCB notes that there are Shari’a compliant foreign exchange risk management transactions available but says nothing about the availability of profit rate risk management transactions.  That suggests as a practical matter there are none.  Further on page 75, it states “Overall non-trading profit rate risk positions are managed by Treasury department, which uses short term investment securities, placement with banks and placement from banks to manage the overall position arising from the Bank’s non-trading activities.”   Frankly, AA doesn’t see how KHCB could be using short term instruments to effectively hedge against the long term interest rate risk it appears to be carrying—up to 20 years!  Perhaps, a treasurer or trader reading this could set AA “straight”. 

4.   So far we’ve looked at half the PRR picture: yield on assets.  KHCB’s funding structure is the second and critical piece of PRR.   Below is a chart developed from KHCB’s 2015 AR Risk Management Note 34 page 75.

KHCB Funding Gap Analysis - FA & LA Portfolio
Months	Up to 3	3 to 6	6 to 12	12 to 36	Over 36
2015
FA & LA	47	17	34	78	211
Funding	96	45	70	43	112
GAP	49	28	36	(35)	(99)
% Cover	204%	267%	205%	55%	53%
2014
FA & LA	53	23	21	66	176
Funding	72	55	68	127	1
GAP	19	32	47	60	(175)
% Cover	136%	236%	325%	191%	1%

Technical Notes: 

1. I’ve deducted both the related assets and funding for bank placements taken and investment in sukuk shown in Note 34 page 75.  The only other profit rate sensitive assets are FA & LA.   Thus, we have a “clean” picture of how the lending portfolio is funded. 
2. Note that a negative “Gap” number means that there is insufficient funding for the respective time “bucket” of assets.  Such “gaps” are a measure PRR. 
3. The longer the life of a fixed rate asset the longer the potential period of negative funding costs.  Therefore, negative gaps in longer dated maturities have more PRR than in the shorter maturities as a general rule.  
4. Also while IFRS doesn’t require that these “banking book” assets be revalued for income or balance sheet purposes, their fair value must be reported in a footnote.  If the damage is severe enough, depositors and creditors may take “flight”.   

Comments on Funding Gap and Profit Rate Risk Analysis:   

1.   At first glance KHCB’s 2015 gap position is an improvement from 2014.  One might argue that the BDH 111 million in total equity covers the gap in the final maturity “bucket” shown.   

2.   The analytical problem is that we have no way of knowing the tenors of deposit funding versus assets.  The “over three years” category covers a wide range of possibilities.  Funding may be for 37 or 120 months. Assets may be for 240 months or 36 months and three days.  Note 34 doesn’t contain enough information to determine what the gap is.  Another criticism and suggestion for changes to reporting standards.  When an institution engages in long dated transactions, it should provide more detailed information on longer tenors. 

3.   IFRS may not have provided the answer.  However, we can thank the good folks at the Basel Committee on Banking Supervision for their Pillar III requirements. 

4.   AR 2015 Note 3.4.6 on page 88 provides residual maturities, not profit rate risk gap maturities.  However, we can use this information to form an opinion about the maximum tenors that KHCB extends on financings and the length time that KHCB is exposed to profit rate risk.  The former should be shown by the maximum tenor in the note.  The latter by the residual maturities themselves as portfolio level residual maturities will tell us how long it will take for outstandings to run off. Note with a fixed rate lender like KHCB, repricing does not take place or is infrequent.  Again a reporting deficiency by use of the “over three years” category. 

5.   Sadly, Basel doesn’t require a similar note on funding, but we can look at the funding gap “over three years category” and form an opinion on likely tenors of deposits based on the “market”. And as discussed below, we can look at additional notes to confirm or deny that opinion. 

Basel III Residual Maturity Note  -- FA & LA
	Up to 1Y	1 to 3Y	3 to 5Y	5 to 10Y	10 to 20Y	20Y+
BHD Millions	99	78	66	90	44	11
Percent	25%	20%	17%	23%	11%	3%

1.   At the beginning of Note 3.4.6, KHCB notes that maximum exposures are 7 years for corporate and 25 years for retail borrowers, unless the Board approves exceptions.   Note that leasing accounts for all the exposure over 20 years. 

2.   Looking at the chart immediately above it seems unlikely that KHCB has found matching funding for such long tenors.  Who is placing 5 year, much less 10 or 20 year money with Islamic banks or other banks?  What depositors are placing 10 or 20 year money with regional commercial banks? How many depositors are placing that sort of money with investment grade global banks? 

3.   But there’s another way to get an insight into deposit tenors.  Note 8.3 on page 98 provides a breakdown of “interest” paid on IAH for 2015 and 2014.  The absolute amount of interest paid falls off dramatically after 12 months. Minimal amounts of “interest” are shown for 18 and 24 month Mudharab accounts in both 2015 and 2014.  How minimal? Less than 1% of the total interest paid to IAH holders. That suggests deposits in the 12 to 36 month “bucket” are largely in the 12 month category. And thus despite the apparent “match” there is a funding gap in this “bucket”.

4.   But where are the 36 month and over IAH deposits shown in Note 34 as representing 99% of the PRR Gap match funding in this bucket.  This is the most risky time period for PRR. Strangely there is no category for these deposits.  Since this maturity “bucket” holds over BHD 112 million or over 30% of all IAH deposits, it seems strange that there isn’t a separate category.  It’s certainly “material” by typical accounting standards. 

5.   There is a category for VIP Mudharab accounts.  Could this be the over 36 month category? Doesn’t look like it. On the following page these accounts are being paid 2.00% which is lower than the 6 month Mudharab “interest” of 2.69%.   Doesn’t seem like a preferential rate for VIPs but then the tenor is unknown because it is unspecified.  Maybe a variant of qard hassan?  AA doesn’t think so.  Also the total interest paid to the VIP IAH is 14% of total interest paid.  It would seem that interest for the more than 36 months deposits should be at least 30% of the total paid in line with their percentage of total IAH deposits.  But it is not. 

6.   AA has no explanation for either #4 or #5 above, and thus the tentative conclusion is that KHCB’s profit (interest) rate risk gap remains substantial and there is significant income risk. 

7.   In an environment where rates are likely to increase driven by the US FRB, KHCB is likely to face earnings pressure (another euphemism) as rates rise.  Not exactly a good strategic "fit" for GFH Financial Group which is looking for stable income not heavily influenced by global factors.

Analyzing KHCB’s Prospects – The Way Forward and a First Step

B&B Prepare to Launch AA on His "Deep Dive" into KHCB's Financials and Prospects 

If You Look Closely You Can See AA Holding a Candle Inside the Bathysphere

My 2017 New Year's resolutions include greater use of corporate buzzwords, but not at work where my boss fines the staff at ever increasing levels for repeated use. Hence "deep dive" above.  

As mentioned in the previous post, KHCB’s earnings history doesn’t indicate it is a likely candidate to provide GFH a stable recurring source of earnings to enable GFH’s new strategy.  But past performance is no guarantee of future results. 

Is there information in KHCB’s 2015 Annual Report that can give us an insight into possible future performance?

Yes. 

As a commercial bank, KHCB’s financial health is based on the performance of its financing (lending) activities.  In 2015 and 2014 lending (financing assets and assets for lease financing) were 59% and 57% of total assets.  Financing revenue was 69% and 78% of total revenue in 2015 and 2014 respectively.   As KHCB’s lending business goes, so goes the bank.

How do we get an insight into the future from historical financial data?

One way is to look at potential stress points and the direction and magnitude of trends.  Credit problems at more traditional short tenor commercial banks aren’t quickly fixed.  KHCB is a harder ship to turn around because it is a long tenor fixed rate lender.  

But this exercise like all other forms of fortune telling is not necessarily conclusive.  Banks are black boxes of risk.  Financials do not always capture those risks for a variety of reasons.

Road Map

Before we set out, here’s the proposed itinerary.   

1. Accrued income receivable  
2. Portfolio yield and “profit rate risk” 
3. Provision coverage  
4. Renegotiated loans  
5. Past due but not impaired loans       
6. Collateral coverage 

Let's start our journey of one thousand li with the first step as the Master would.

ACCRUED INCOME (“INTEREST”) RECEIVABLE

An early sign of problems in the loan portfolio often—but not always--is a build-up in accrued interest receivable (AIR) or the “Islamic” equivalent of accrued income receivable as I noted in my earlier post on ADCB.  In such a situation—and this is not a reference to ADCB because we don’t have enough data points to establish a definite trend at that bank—a bank books income into AIR which later turns out to be “air”.  

Think of the UAE banks merrily capitalizing interest on perpetual overdrafts—which meant they were booking interest on accrued but unpaid interest—back in the late 70s until they well and truly hit the wall. 

Or Bahrain International Bank (BIB) capitalizing interest on a loan to a “great” US fast food investment it had made, but not so “great” it could even pay $1 of interest.  Each year AIR went up by the amount of interest on the loan.  Year after year.  That wasn’t the only “funky” thing with BIB’s financials. All of which savvy investors, rating agencies, and others “missed” until BIB’s sudden impact with the wall.

KHCB doesn’t provide any explicit information on AIR, presumably because of the amounts are not “material” as a percentage of assets.   AR FYE 2015 Note 12 “Other Assets” provides information on sukuk income receivables.   A catch all category “other receivables”—where FA & LA AIR most likely is booked—increased by about BHD 3.9 million from 2014.  But no explanation was provided. Other Assets dropped to BDH9.6 at 3Q16.   Even more abbreviated details here don't allow even cursory analysis.  The 2016 AR will have more details, but is likely to have the same opacity as At 2015 so we still won't have conclusive evidence.  If there is an air problem, the amounts don't appear to serious and the drop in 3Q16 suggests there probably isn't a problem. 

The Statement of Cashflows (SOC) sometimes but not always discloses if AIR is increasing (it sure did with BIB as well as BIB’s Other Assets Note).  KHCB’s SOC is of little analytic use because FA & LA income (interest) received seems to be buried along with principal payments and disbursements in a net figure. 

The comments on disclosure of other assets and the SOC are not only meant as criticism but also encouragement for changes to financial reporting, assuming there is an interest in providing financial statement users with useful information. 

As our journey progresses deeper into KHCB's financials expect more criticisms/suggestions, particularly as AA's candle depletes the air in the bathysphere.

KHCB Strategic "Fit" with GFH - Historical Context

At the End of a Wild Ride One Winds Up Where One Started 

For the discussion about KHCB’s strategic fit with GFH, a bit of context by way of historical data, though as I noted in my 1 December post, the success of GFHFG’s strategy depends on future performance not past.

Some introductory comments.

Since my earlier analysis, I’ve introduced two comparable, Bahrain Islamic Bank (BIsB) and Qatar Islamic Bank (QIB) and provide data for two periods:  the last ten and five years. 

Definitions:

1. GFH includes income from KHCB.  
2. GFH X KHCB does not.
3. Amounts are in millions of US dollars (GFH's base currency).
4. BD and QR have been translated to US dollars using respective official peg rates. 
5. As before, STDVP = Standard Deviation of the Population and STDVS = Standard Deviation of the Sample.

Let’s start with the long view – ten years financial data.

Net Income Statistical Analysis 2006-2015
	Mean	STDVP	STDVS
GFH	-$22.87	299.36	315.55
KHCB	$15.41	31.34	33.04
GFH X KHCB	-$30.04	293.96	309.86
BIsB	-$6.82	59.71	62.94
QIB	$386.18	68.55	72.26

Over the ten-year period, KHCB generated some $154 million equivalent in net profit.  But this was largely due to two fat years—2007 and 2008—whose net profit of $128 million (note that’s 83% of the ten year’s total) was driven by investment banking fees (revenue not net profit) of $128 million.  Revenue that has not recurred and is likely to in the future. As that indicates, the commercial banking business by itself has not been wildly successful (first euphemism of this post) over the period.  

That being said, KHCB increased GFH’s net income by about $71.7—GFH’s share of the $154 million—but really didn’t “move the needle” much (AA’s corporate buzzword of the post).  The mean improved slightly, but volatility barely moved.

The ratio of STDP and STDS to mean for GFH, KHCB, and BIsB indicates the high volatility of results.  These metrics are definitely not indicators of “stable or recurring” income or profitability.  The negative means and rather “modest” (second euphemism) positive mean is another indication of weakness.

The story is much different at QIB.  There the STD is a fraction of a rather healthy mean.  In the case of QIB, we’d predict positive earnings as the most likely outcome using the above data.  Not so with the others.

Now for a five year view.

Net Income Statistical Analysis 2011-2015
	Mean	STDVP	STDVS
GFH	$0.44	11.55	12.91
KHCB	-$4.17	24.27	27.13
GFH X KHCB	$2.42	9.21	10.29
BIsB	-$14.32	49.23	55.04
QIB	$411.87	70.45	78.77

During this five year period, two things are clear about KHCB’s performance: 

1. It was more volatile than GFH’s. 
2. KHCB had a net loss over the period driven by credit problems. GFH did not, but just barely.     

In this period, GFH would have been better off without KHCB as net income would have been higher by some $10 million and volatility lower.  But GFH’s earnings would still not be stable.  Thus, with or without KHCB GFH did not achieve stable earnings.  It doesn’t require sophisticated math or even a calculator to figure out that ROE was dismal.  My earlier post has comparative ROE figures. As well, net income over the period did not rise even to “hobby” levels on an absolute basis.  

Based on a historical analysis, there is little to support KHCB as a pillar of GFH’s new strategy. 

What GFH needs is for KHCB to deliver not only a stable income but also much larger quantum of positive net income.  Neither of which KHCB has shown any ability to deliver.

But things change.

Blackberry was once the leading provider of business cell phones.   At  that point no one had ever heard of an IPhone.     

We’ll turn our attention to that issue in coming posts.